OECD Economic Outlook, Volume 2019 Issue 2

Euro area

Growth is projected to remain subdued, with little prospects of a recovery over the coming two years. Modest growth in external demand, global trade tensions and policy uncertainty will limit the pick-up in exports and business investment. Household saving is expected to continue to rise, further weakening the prospects for demand growth. Inflation will remain low.

Very accommodative monetary policy is appropriate given the weakness of expected inflation, but a sustainable resumption of growth and a durable return of inflation to target will require further fiscal easing as well. Taking advantage of the enhanced fiscal space afforded by very low interest rates, public investment should increase in countries with low public debt, inter alia to support climate change mitigation and long-term economic growth. A fresh impulse towards stronger European integration, notably by deepening the single market, completing the banking union and developing common fiscal tools, would foster resilience and productivity growth.

The slowdown is becoming entrenched

The euro area economy has slowed further in the course of 2019. Continued deterioration in external demand, persistent global trade tensions and enduring uncertainty surrounding Brexit have severely hampered exports. Investment weakness has also tended to worsen. The labour market has remained robust, with further reductions in unemployment and the continuation of moderate wage dynamism, which has translated into purchasing power gains given subdued inflation. However, growth in private consumption has somewhat declined, reflecting higher household saving, probably related to precautionary saving in a context of rising uncertainties. Manufacturing has been hit hardest by the slowdown, but confidence in services has also shown signs of faltering.

Confidence and labour market: Euro area

1. Private service sector firms.

2. Nominal wages per employee.

Source: IHS Markit; and OECD Economic Outlook 106 database.

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Euro area: Demand, output and prices

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Fiscal space and fiscal expansion: Euro area

1. Low-debt - OECD - euro area countries include: Austria, Finland, Germany, Ireland, Latvia, Lithuania, Luxembourg, the Netherlands, Slovenia and the Slovak Republic. Estonia is excluded due to the limited depth of its sovereign bonds market.

2. High-debt - OECD - euro area countries include: Belgium, France, Greece, Italy, Portugal and Spain.

3. Measured in percent of potential GDP.

Source: OECD Economic Outlook 106 database.

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Germany and Italy remain the countries most affected by the current slowdown, reflecting in part their strong reliance on manufacturing, compounded in the case of Germany by greater dependence on exports and specific issues in the automobile industry. Countries more reliant on domestic demand, such as France and Spain, have resisted better to the slowdown so far but are now also being impacted through intra-area spillovers.

Fiscal and structural reform efforts need to be stepped up

Monetary accommodation has been further increased. In September, the ECB cut the deposit facility rate by 10 basis points (to -0.5%), vowing to keep policy rates at their present or lower levels until the inflation outlook robustly converges to a level close to 2%. In addition, a two-tier system for reserve remuneration was introduced (exempting part of banks’ excess liquidity from the negative deposit rate), and the conditions of targeted longer-term refinancing operations (TLTRO) were made more attractive. Furthermore, monthly net asset purchases of EUR 20 billion restarted in November. Throughout the projection horizon, net purchases are expected to continue at this pace, and policy rates are set to remain unchanged. However, if unaccompanied by other policies, the impact of ECB policy action on aggregate demand will likely be modest.

The euro area aggregate fiscal stance is expected to remain slightly expansionary, with a cumulative impulse of about 0.5 percentage points of GDP over two years (2020-21). This will support activity to some extent. However, the planned fiscal easing is largely uncorrelated with the available fiscal room for manoeuvre, and does not mainly involve stronger public investment, which remains below its 2008 levels. Euro area countries with small or moderate public debt-to-GDP ratios have considerable fiscal space, which low and declining interest rates have boosted further. This space should be used for a sizeable increase in public investment, addressing national needs and generating cross-border spillovers. In this context, high priority should be given to meeting climate targets, requiring at least yearly 1% of GDP of additional investment in areas like energy grids, efficiency of buildings and electric vehicles infrastructure.

Coordinated efforts are also needed on the structural front to improve cyclical stabilisation, help offset negative shocks from rising trade restrictions and increase growth potential. To better reconcile stabilisation with sustainability, European fiscal rules should be simplified and refocussed on expenditure growth anchored to a debt ratio target. The new Budgetary Instrument for Convergence and Competitiveness should be swiftly deployed and subsequently expanded, with a view to creating a common fiscal capacity able to weigh on the area’s fiscal stance. Completing the banking union, notably through common deposit insurance and a common fiscal backstop to the Single Resolution Fund remains the highest priority to create a truly European banking system, which would facilitate monetary policy transmission and enhance private risk sharing. Progressing towards capital markets union would diversify funding sources to firms. Renewed efforts to strengthen research and innovation policies and to deepen the single market, by tackling widespread segmentation in services and network industries, would spur trade and investment in Europe, helping to offset the current sources of weakness in activity and paving the way for stronger medium-term growth.

Growth is projected to remain subpar

GDP growth is projected to remain subdued, at just over 1%, over the coming two years, as enduring weak external demand, policy uncertainty and low confidence continue to hamper exports and investment. Support to activity from private consumption and public expenditure is set to be limited by a further increase in the household saving rate and by the modest size of the planned fiscal expansion. The unemployment rate is projected to broadly stabilise, but subpar growth will help keep inflation far below 2%. Although somewhat declining, the euro area current account surplus will remain large and concentrated in a few countries.

Exports and investment would weaken further in the event of an escalation of trade tensions with the United States, a stronger-than-expected slowdown in China or prolonged uncertainty about the content of an eventual trade deal between the European Union and the United Kingdom. The ensuing worsening of the slump in manufacturing activity would heighten risks of contagion to the services sector. Downward pressures on services would be compounded if falling consumer confidence led to further increases in precautionary household saving. On the upside, coordinated efforts to increase public investment and complete the economic and monetary union would reduce policy uncertainty and help boost confidence and productivity.